Vertical Integration and Investor Protection in Developing
Countries
Rocco Macchiavello
Oxford (Nu¢ eld College) and CEPR
July 2009
Abstract
The industrial organization of developing countries is characterized by the pervasive use
of subcontracting arrangements among small, …nancially constrained …rms. This paper asks
whether vertical integration relaxes those …nancial constraints. It shows that vertical integration
trades o¤ the bene…ts of joint liability against the costs of rendering the supply chain more
opaque to external investors. In contrast to the commonly held view that pervasive input and
capital market imperfections are conducive to vertical integration, the model predicts that the
motives for vertical integration are not necessarily higher in developing countries. In particular,
vertical integration is more likely to arise at intermediate levels of investor protection and better
contract enforcement with suppliers reduces vertical integration only if …nancial markets are
su¢ ciently developed. Evidence supporting both predictions is discussed.
Keywords: Vertical Integration, Industrial Development, Financial Constraints, Joint Liability, Trade Credit, Community-based Industries.
JEL Codes: O12, O16, D23, G30, L22.
I have especially bene…ted from comments by Patrick Bolton, Mike Burkart, Ian Jewitt, the editor Dilip Mookherjee and two anonymous referees. I also thank Abhijit Banerjee, Mikhail Drugov, Aytek Erdil, Leonardo Felli, Andreas
Madestam, Enrico Sette and Jean Tirole and participants in seminars at Bristol, FMG, LSE, MIT (Development
Lunch), Nu¢ eld College, SOAS, UBC, Uppsala and at ESSET 07 (Gerzensee), ESWC 2005 and NEUDC 07. All
errors are mine. E-Mail: [email protected]¢ eld.ox.ac.uk
1
1
Introduction
The industrial organization of developing countries is characterized by the pervasive use of subcontracting arrangements among small …rms. Evidence of these subcontracting arrangements in
the developing world (see, e.g., the footwear industry in Taiwan (Levy (1990)), Mexico (Woodru¤
(2002)) and Brazil (Schmitz (1995)) contrasts with the intuition that, in response to input market failures and poor contract enforcement, …rms should tend to be larger and more vertically
integrated in those countries (see, e.g., Khanna and Palepu (1997, 2000)).1 A second well-known
characteristic of the industrial organization of developing countries is that underdeveloped …nancial
markets are a serious constraint to investment for small and medium-sized …rms (see, e.g., Banerjee
and Du‡o (2004) for a survey of the literature).2 This paper argues that the relationship between
(capital and input) market development and vertical integration is a complex one. In contrast to
commonly held views, the motives for vertical integration are not necessarily higher in developing
countries. In particular, the relationship between investor protection and vertical integration is,
instead, likely to take an inverted U-shape.
To explore the connection between …nancial constraints and vertical integration, a …rst necessary
step is to ask whether vertical integration makes it easier or harder to raise external …nance. Section
2 starts by introducing an incomplete contract model in which a seller can produce a good that can
be used by a buyer or sold on a spot market. Which of those two trading con…gurations yields a
higher surplus depends on market conditions, which are unknown at the time of initial contracting.
Neither the seller nor the buyer has cash, and both need to borrow from an external investor. Since
owners can steal part of the pro…ts of their …rms, rents need to be provided in order to insure
repayment of the loan. This implies that entrepreneurs can only pledge a fraction of the pro…ts
of their project to external investors and therefore face borrowing constraints. In environments
in which it is hard to borrow, the choice between vertical integration and non-integration is then
1
Acemoglu et al. (2006) show that this anecdotal observation is not explained by di¤erences in industrial composition: developing countries have relatively larger shares of …rms in industries that are relatively more vertically
integrated in richer countries. Rajan and Zingales (1995), Macchiavello (2006) and Kim and Shin (2007) also provide
evidence that systematic di¤erences in the degree of vertical integration across countries correlate with the degree of
…nancial development.
2
The paper provides a framework to think about small and medium-sized enterprises, for which borrowing constraints are likely to be important. In focussing on borrowing constraints we do not deny that other characteristics of
the business environment in developing countries have potentially large e¤ects on the incentives of …rms to vertically
integrate (e.g., low skills in the labour force, labour regulation, other reasons pushing …rms into the informal sector).
2
taken to maximize the pledgeable income (i.e., the expected returns that can be promised to the
investor) of the two projects.
Section 3 highlights the main mechanisms through which the choice between vertical integration
and non-integration a¤ects pledgeable income. The main message is that, from a …nancial point of
view, vertical integration trades o¤ the bene…ts of joint liability against the costs of rendering the
supply chain more opaque for the external investor. The positive “joint liability” e¤ect associated
with vertical integration comes from the fact that, given …nal product market conditions, the
pro…ts of two vertically related …rms depend, through bargaining, on input market conditions and
are therefore negatively correlated. When the price of the input is high, so are the pro…ts of the
upstream …rm. When, instead, the price of the intermediate input is low, it is the downstream …rm
that bene…ts. Negatively correlated returns make joint liability relatively more attractive. Vertical
integration, however, comes with a negative “demonitoring” e¤ect. Under vertical integration the
…nancier of the …rm can seek repayment from a single entrepreneur but not from an employee,
whilst under non-integration she can seek repayments from both the downstream and upstream
owners. In other words, under non-integration the investor can claim repayments from two parties
rather than one, as well as over earnings which represent a compensation for e¤ort.
The trade-o¤ implies that vertical integration is preferred when pledgeable income is higher. For
instance, a high cash ‡ows at the end of the chain implies that the optimal …nancial structure chooses
a relatively low level of debt, which guarantees repayment regardless of input market conditions.
Under those circumstances, vertical integration achieves higher pledgeable income since it insulates
the pro…ts of the …rm from input market conditions. When the value of production at the end of the
chain is low, instead, the optimal contract sets a high debt, which is repaid only when input market
conditions are favorable to the downstream …rm. While the pledgeable income of an integrated
…rm is equal to that of a non-integrated downstream …rm, non-integration allows the investor to
receive the pledgeable income of the upstream …rm as well and is therefore preferred.
Section 4 presents two extensions to the baseline model and derives testable predictions linking
the institutional environment to the vertical integration decision. The two extensions combine the
baseline model implication that vertical integration is preferred when pledgeable incomes are higher
with well known mechanisms associated with imperfect contracting and borrowing constraints.
The …rst extension introduces a distinction between the degree of “investor protection”(i.e., the
3
extent to which entrepreneurs can steal pro…ts from external investors) and “contract enforcement”,
i.e., the extent to which buyers can avoid paying suppliers for the input provided. In particular,
we assume that, in stealing the pro…ts of her …rm, the buyer can also default on a fraction of the
(trade) credit extended by the supplier. As a consequence of this imperfection, to ensure loan
repayment the …nancial contract must leave higher rents to the entrepreneur.
Imperfections in the enforcement of contracts between the seller and the buyer have an ambiguous e¤ect on vertical integration. On the one hand, since input transactions among independent …rms occur at higher prices, the rents necessary to ensure repayment are higher under
non-integration than under vertical integration. This e¤ect captures the common argument that
vertical integration is preferred in the presence of contractual imperfections with input suppliers.
On the other hand, by increasing the rents necessary to ensure loan repayment, imperfect contract
enforcement with the input supplier reduces the income that can be pledged by the two …rms.
According to the logic of the baseline model, this favors non-integration.
The interplay of those two e¤ects implies that the relationship between vertical integration
and the institutional environment is complex. In particular, contract enforcement and investor
protection are complementary determinants of vertical integration, in the sense that non-integration
is more prevalent when both are either relatively high or relatively low. The overall quality of the
institutional environment, in terms of both investor protection and contract enforcement, therefore,
has a non-monotonic e¤ect on the incentives for vertical integration.
The second extension to the baseline model introduces product market competition at the end
of the value chain. The interplay between product market competition and the positive relationship
between vertical integration and pledgeable income gives an additional mechanism through which
the relationship between investor protection and vertical integration is non-monotonic. At very
low levels of investor protection, it is not possible to …nance both the downstream and upstream
units. The industry is then characterized by small, vertically disintegrated …rms that outsource
their components in the market. As investor protection increases, two e¤ects kick in. On the
one hand, as access to …nance gets easier, it becomes possible to expand the …rm and …nance
the investments required to set up the upstream unit as well. This e¤ect pushes towards vertical
integration. On the other hand, better investor protection fosters entry of …rms in the industry,
increases competition, and eventually leads to lower equilibrium cash ‡ows at the end of the chain.
4
This e¤ect, as emphasized above, pushes towards non-integration. The …rst e¤ect is stronger at
relatively low levels of investor protection; while the second e¤ect is stronger at higher levels of
investor protection.
Section 5 confronts the theoretical predictions with empirical evidence based the historical
experience of the textile industry in the nineteenth century as well as contemporary cross-country
studies. Section 6 discusses the implications of relaxing many of the assumptions alongside with
other possible extensions to the model.
Related Literature
This paper contributes to the literature on the relationship between …nancial development and
the industrial organization of developing countries. Banerjee (2004) and Banerjee and Munshi
(2004) present insightful evidence on the relationship between …nancial constraints and vertical
integration in industries based within communities in India. The model in this paper provides
an analytical treatment of the issues treated in those papers. Mookherjee (1999) also provides
a discussion of the costs and bene…ts of vertical integration in less developed countries, but he
focuses on the role of uncertainty in input supply. More recently, Kranton and Swamy (2006) have
studied the microeconomics of exporting in a model that also features multiple hold-up problems
between various actors along the supply chain (exporters, agents and producers). They discuss why
vertical integration might not be feasible in institutionally poor environments, which complements
the insights of this paper. Moreover, they provide an analysis of putting-out systems, a hybrid
organizational form closely related to some of the discussion in this paper. Finally, this paper is
related to the theoretical literature on micro…nance and joint liability contracts across …rms in
developing countries (see, e.g., Ghatak and Guinnane (1999) and Ghatak and Kali (2001)). An
important di¤erence, however, is that in our context the joint liability of the two productive units
is linked to an input transaction.
This work is also closely related to the literature on the theory of the …rm. While we do not
intend to downplay the importance of non-contractible investments in determining the vertical
integration decision (a view formalized in the property right approach (see, e.g., Hart (1995)), this
paper emphasizes how vertical integration a¤ects the ex-post (governance) relationship between
the external investor and the entrepreneurs, and is therefore closer in spirit to the transaction
costs approach to …rm boundaries (e.g., Williamson (1971)). Property rights theories of the …rm
5
with …nancially constrained entrepreneurs (see, e.g., Legros and Newman (2004)) predict that the
allocation of control rights is twisted in favour of the entrepreneur with more ex-ante bargaining
power or wealth. The ex-ante distribution of wealth and bargaining power, however, might be
context speci…c and di¢ cult to observe, making those theories hard to test. The approach in this
paper emphasizes the …nancial properties of the organizational form and allows for predictions that
do not depend on those details. Finally, In de…ning a …rm as a nexus of contracts characterized
by a centralized allocation of control rights and joint liability, the paper borrows from the legal
literature (e.g., Cheung (1983), Hausmann and Kraakman (2001)), as well as from the work of
business historians (e.g., Lamoreaux (1998)).3
2
The Model
Set up
Consider two managers, a buyer and a seller, respectively in charge of two di¤erent projects:
a downstream (d) plant and an upstream (u) plant. The two managers have no cash and borrow
from an investor to …nance the investments required to start their respective plants. The upstream
unit produces a good that can be used by the downstream unit or sold to an external market. The
two managers are aware of the possibility that certain features of the input may make it best suited
to be traded on the spot market, but they cannot foresee the nature of these features, and hence
cannot write an ex-ante contract which is contingent on the nature of ex-post trade.
The production process generates …nal cash ‡ows V: The input can be purchased (respectively
sold) on the spot market at price p (respectively p0 ). There is ex-ante uncertainty over the prevailing
input market conditions. To simplify, assume that with probability
the input can be purchased
at price p = p < V; otherwise p = p < p: For simplicity, let us assume that p0 = p with
< 1: The
upstream manager can always produce an appropriate input at cost c; where p < c < p: A fraction
of the costs is monetary and corresponds to a …nancial outlay (for example, it could correspond
to the purchase of tools). The remaining fraction 1
; however, is an e¤ort cost that cannot be
transferred and is borne by the upstream manager, for example the opportunity cost of working
3
The trade-o¤ associated with vertical integration is reminiscent of the informal discussions in Williamson (1971)
and Holmstrom (1999). This paper is also related to the literature on trade credit (see, e.g., Burkart and Ellingsen
(2004)) and internal capital markets (see Stein (2003) for an excellent survey). The link between vertical integration
and investor protection distinguishes this paper from those literatures.
6
to produce the intermediate input. Since p < c < p < V; when p = p; the upstream manager is
not cost-e¤ective, and the input should be procured on the market. When p = p; however, the
upstream manager is cost-e¤ective and it is strictly more pro…table for the input to be produced
by the upstream manager and to be sold to the downstream manager. The parameters
and
therefore capture the speci…city of the relationship.
As is commonly assumed in the incomplete contracts literature, the realization of the state of
nature is observable but not veri…able: it is observed by the two managers but not by third parties
such as investors and courts.4
Ownership
Ownership determines residual control rights over the use of the input. We focus on two di¤erent
con…gurations. Under non-integration the two units are separately owned and managed …rms. In
the absence of an enforceable contract, two independent …rms trade with each other if and only if
the two owners agree on a suitable price P for the input. Under vertical integration the owner of the
…rm, i.e., the downstream manager, bargains with her employee, i.e., the upstream manager, over
wage w, but can impose by …at whether the two divisions of the integrated …rms should trade with
each other or trade on the spot market. Both P and w are negotiated through an ex-post e¢ cient
bargaining process in which the downstream manager has the right to make a take-it-or-leave-it
o¤er to the upstream manager.5
Control over …nancial streams is transferred with ownership. Only a fraction ' of the monetary
pro…ts are veri…able, and therefore an owner can always guarantee a fraction (1 ') of the monetary
pro…ts of the …rm for himself.6 The parameter ' is a proxy for the degree of external investor
protection in the economy.7
In contrast to repayment to an investor lending capital, the model assumes that owners cannot
4
Prices cannot be veri…ed by courts because the exact features of the required input cannot be described. The
court observes many input prices on the market, but does not know which input is appropriate.
5
General divisions of surplus between the two managers could be considered without a¤ecting the main results.
6
This assumption is stronger than necessary. What is important for the analysis is that repayments to investors
cannot be made fully contingent on the realization of pro…ts. Assuming a linear stealing technology avoids a bias
in favour of (respectively, against) vertical integration purely originating from increasing (respectively, decreasing)
returns in such technology.
7
We assume that control over …nancial streams cannot be (fully) separated from ownership because (part of) the
returns cannot be veri…ed. Ownership entails the right to sign contracts with third parties that could be used to
generate private bene…ts for the owner. The assumption that employees cannot steal is made to focus our attention
on the agency con‡ict between the …rm(s) and the investor.
7
avoid repayments to employees and suppliers. Section 4.1 relaxes the assumption and considers a
more general case in which the owner can avoid payments to employees and input suppliers as well.
In the remainder of the text, the downstream manager will also be called buyer under nonintegration and owner under vertical integration. Similarly, the upstream manager will also be
called seller under non-integration and worker (or employee) under vertical integration.
Initial Contract and Timing of Events
Neither manager has cash, and both needs to borrow in order to …nance the start up costs
of the two projects. These costs are denoted by kd and ku for the downstream and upstream
units, respectively. If either of the two managers fails to get capital to …nance her project, she
can start a smaller project that requires no initial capital disbursement (she could, for instance,
become self-employed in the informal sector). We normalize the payo¤ of starting such a business
with no capital to be equal to zero. Since we are interested in determining i) which organizational
form raises more external funds, and ii) which projects can be …nanced by external investors, the
analysis assumes that there is a unique risk-neutral investor who has all the ex-ante bargaining
power. Contracts are thus signed to maximize the pledgeable income of the two projects, subject
to the participation constraints of the two managers.8
Only simple debt-like contracts are feasible. The investor holds a debt-like claim B over the
pro…ts of a …rm. When the …rm is integrated there is a unique B: When the two …rms are not
integrated, the investor holds claims Bd and Bu on the pro…ts of the downstream and upstream
…rms, respectively. The monitoring costs associated with equity-like contracts are assumed to be
prohibitively high.
To summarize, the timing of events is as follows (see Figure 1). At date 0 contracts are signed.
First, either an integrated …rm or two non-integrated …rms are created (allocation of control rights).
Then, the …nancial contract(s) between the owner(s) of the …rm(s) and the investor are signed. At
date 1/2, the state of nature is realized and observed by the managers. Given the ownership
con…guration, the two managers bargain at date 1 over the input transaction. At date 2 pro…ts are
realized. The owner(s) then decide(s) whether to hide pro…ts or not. Finally, if pro…ts have not
been hidden, existing …nancial contracts are executed.
8
Even in a competitive credit market, two cash constrained managers might try to maximize the amount they can
raise from the external investor in order to transfer rents according to the initial distribution of bargaining power, as
discussed in Section 6.
8
Figure 1: Timing of Events
t=0
t = 1/2
t=1
t=2
Contracts are signed. State of nature is realized Given debts and ownership - Profits are realized.
and observed by managers structure, managers bargain - Owner(s) decide whether to
- Vertical structure
over input transaction
Financial contract(s)
hide the profits of the firm(s)
We focus for simplicity on the case
' 1; and relegate to Section 6 a short discussion of
the more general case. In order to avoid a taxonomy of cases, we focus on the case in which,
under non-integration, the participation constraint of the upstream manager is not binding, i.e.,
(1
') (p
3
The Costs and Bene…ts of Vertical Integration
3.1
c) > (1
)c:
Derivation of Pledgeable Incomes
Pledgeable Income under Vertical Integration
Under vertical integration the investor chooses the debt level B in order to maximize the pledgeable income of the integrated …rm. With probability
the market price for an appropriate input
is p = p > c: The employee should produce the input at cost c; and the two divisions of the integrated …rm should trade together. The owner of the …rm makes a take-it-or-leave-it o¤er w to her
employee. Since the downstream manager is the owner of the …rm, the employee does not have the
right to sell the input on the market at price p; and therefore her outside option in the bargaining
game is equal to zero. The owner then o¤ers a wage w = (1
)c that exactly compensates the
employee for the costs associated with e¤ort, and the o¤er is accepted. The owner of the …rm also
purchases the necessary tools and input required by the employee to produce the input at cost c:
The monetary pro…ts (gross of debt repayments) of the …rm are given by
(p) = V
c: As
owner of the …rm, the downstream manager repays debt B if this is more pro…table than hiding
9
the monetary pro…ts, keeping a fraction 1
i.e., if B
'(V
' of them. This happens if
(p)
B
(1
') (p);
c):
Similarly, with probability 1
the market price for an appropriate input is p = p < c. The
input is procured on the spot market at price p. The monetary pro…ts (gross of debt repayments)
of the …rm are given by
B
'(V
(p) = V
p; so that the owner of the …rm repays debt B if and only if
p):
The investor trades o¤ a higher debt level B with a higher probability that the debt is repaid.
The investor can set B = '(V
B = '(V
c) and be repaid regardless of the state of the world, or set
p) and be repaid only with probability 1
: When V is higher, the …rst option
becomes relatively more pro…table. The following proposition summarizes the previous discussion.
Proposition 1 The pledgeable income of an integrated …rm, denoted Pint ; is given by
Pint = ' maxf(V
c); (1
)(V
p)g:
(1)
The pledgeable income of an integrated …rm is i) increasing in the degree of investors’protection
', ii) decreasing in the (expected) cost of the input (c;
and p), iii) increasing and convex in
downstream cash ‡ows V; and iv) independent of the composition of input costs :
Pledgeable Income under Non-Integration
Under non-integration the two units are two independent …rms managed by two separate owners.
The investor chooses debt levels Bd and Bu in order to maximize the joint pledgeable income of
the two non-integrated …rms.
With probability 1
the market price for an appropriate input is p = p < c. The input should
be procured on the spot market at price p: The monetary pro…ts (gross of debt repayments) of
the downstream and upstream …rm are respectively given by
owner of the downstream …rm repays debt Bd if and only if Bd
d (p)
=V
'(V
p and
u (p)
= 0: The
p); while the owner of the
upstream …rm never repays debt.
With probability
the market price for an appropriate input is p = p > c: The two …rms
should trade together. The owners bargain over the price P for the input. Since the downstream
manager has all the bargaining power, she proposes a price P = p ' p > c for the input, and her
10
o¤er is accepted by the seller. The monetary pro…ts (gross of debt repayments) of the downstream
and upstream …rms are respectively given by
repays the debt if and only if Bd
Bu
' (p
'(V
d (p)
= V
p and
u (p)
= p
c: The buyer
p): Similarly, the seller repays the debt if and only if
c) :9
As for the case of integration, the investor trades o¤ a higher debt level Bi in each …rm i 2 fd; ug
with a higher probability that the debt will be repaid. For the upstream …rm, the optimal debt level
is obviously given by Bu = ' (p
c) : This debt is repaid with probability ; and the pledgeable
income of the upstream …rm is given by Pu = ' (p
…rm is given by Pd = ' maxf(V
p); (1
)(V
c) : The pledgeable income of the downstream
p)g:
The following proposition summarizes the previous discussion.
Proposition 2 The total pledgeable income of two non-integrated …rms, denoted Pni ; is given by
Pni = '[maxf(V
p); (1
)(V
p)g + (p
c)]:
(2)
The total pledgeable income of two independent …rms Pni is i) increasing in the degree of
investors’protection ', ii) increasing and convex in downstream cash ‡ows V; and, iii) decreasing
in the share of monetary costs borne by the owner . In contrast to the pledgeable income under
integration Pint , Pni depends on p and
: Pni depends on p because when the two …rms trade
together the price p = p prevailing in the input market pins down, through bargaining, the division
of surplus between the two …rms. It also depends on
because of a fundamental accounting
di¤erence between vertical integration and non-integration. While the value added and the pro…ts
are equal along the chain under the two organizational forms, the monetary pro…ts are not. This
is because under integration the non-monetary costs (1
)c are transformed into a monetary
disbursement corresponding to a wage, while under non-integration they are not.
Under non-integration the division of surplus between the two …rms does not depend on the debt
levels Bd and Bu : In fact, the pledgeable income Pni is simply given by the sum of the pledgeable
incomes of the two …rms, i.e., Pni = Pd + Pu :10
9
Note that the seller’s monetary payo¤ is given by (p
c) Bu which is strictly larger than her e¤ort cost
(1
)c, under the assumption (1 ') (p
c) > (1
)c: If, instead, (1 ') (p
c) < (1
)c; the participation
constraint of the upstream manager is binding and Bu = p c.
10
Moreover, since the buyer has all the ex-post bargaining power and ' 1, Pd is independent of whether …rm u
11
3.2
Comparison of the two structures
The next proposition compares the pledgeable income under the two organizational forms and provides necessary and su¢ cient conditions under which vertical integration delivers a higher pledgeable income than non-integration.
Proposition 3
surplus p
1. If the monetary pro…ts
(p
c) of an upstream …rm are larger than the
c in the intermediate input market, then non-integration always has a higher
pledgeable income, i.e., Pni > Pint :
2. If, instead, (p
c)
p
c; there exists a threshold V such that Pint
the …nal good V is higher than V ; i.e., V
V : Moreover,
@V
@
< 0;
@V
@
Pni if the value of
< 0 and
@V
@'
= 0:
Depending on parameters, the pledgeable income might be higher either under vertical integration or under non-integration, as illustrated in Figure ??. Figure ?? plots the pledgeable incomes
under vertical integration and non-integration as a function of product market cash ‡ows V:
When V is su¢ ciently low, it is optimal to set a high debt level which is repaid only when
input market conditions are favorable to the downstream …rm, i.e., when p = p. This implies that
the debt capacity of an integrated …rm is equal to the debt capacity of the downstream …rm under
non-integration, i.e., Pd = Pint = '(1
)(V
p): Under non-integration, however, the investor can
also seek repayment from the upstream owner, Pu = ' (p
c): Non-integration then dominates
since under vertical integration the investor cannot seek repayments from an employee, whilst under
non-integration she can seek repayments from the upstream …rm owner, thus laying claims on the
earnings of this agent as well. I label this negative e¤ect of vertical integration “demonitoring”
e¤ect.11
At higher levels of V; however, it becomes optimal to set a level of debt which is repaid regardless of input market conditions. Relative to the pro…ts in a non-integrated chain, the pro…ts
of the vertically integrated …rm are relatively more insulated from input market conditions, and
has been …nanced or not (and vice versa). All …nancial externalities have been removed and the optimal …nancial
contract can be obtained independently for each …rm. The more general case is brie‡y discussed in Section 6.
11
This e¤ect resonates with the discussion in Williamson (1971) about the increasing interest rates associated
with vertical integration: “ (...) unable to monitor the performance of large, complex organizations in any but
the crudest way (...) investors demand larger returns as …nance requirements become progressively greater, ceteris
paribus”. Garcia-Appendini (2006) …nds evidence that banks extend loans based on information about trade-credit
relationships between the …rm and its suppliers. This information becomes unavailable if the …rm is vertically
integrated.
12
therefore vertical integration becomes more attractive. To see why this is the case, note that under
non-integration the downstream …rm pays the input from the upstream …rm a price equal to p;
which implies an associated pledgeable income equal to Pd = ' (V
p). Under vertical integra-
tion, instead, the …rm pays for the intermediate input only a cost equal to c; with corresponding
pledgeable income equal to Pint = '(V
c): The di¤erence in the pledgeable incomes of a vertically
integrated …rm and a non-integrated downstream …rm is therefore positive and at most equal to
'(p
c): I label this positive e¤ect of vertical integration “joint liability” e¤ect.
If ' (p
c) > '(p
c); therefore, vertical integration is always dominated by non-integration,
since the negative demonitoring e¤ect is always larger than the positive joint liability e¤ect. This
corresponds to the …rst case in Proposition 3. If, instead, '(p c) > ' (p
c); vertical integration is
preferred for su¢ ciently high V; an important result for the analysis in Section 4.2. This corresponds
to the second case in Proposition 3 which is illustrated in Figure ??.12
Higher
makes both the demonitoring and the joint liability e¤ects stronger, and its e¤ects
are therefore a priori ambiguous. On the one hand, a higher
the upstream …rm,
@Pu
@
= '(p
increases the pledgeable income of
c); strengthening the demonitoring e¤ect: On the other hand, it
reduces the pledgeable income of a non-integrated downstream …rm by more than the pledgeable
income of a vertically integrated …rm,
@Pd
@
=
'(V
liability e¤ect. This second e¤ect dominates if V
integration always becomes more likely as
@Pint
;
@
p)
thereby amplifying the joint
V = (p
c + p) and, since V < V ; vertical
@V
@
< 0).13 The model therefore predicts
increases (i.e.,
that, in a cross-section of …rms, two plants belonging to a vertically integrated …rm should be more
likely to trade with each other than are two plants belonging to two separated …rms. Mullainathan
and Scharfstein (2001) …nds evidence supporting this prediction.14
Before studying two extensions to the baseline model, it is worth noting how vertical integration
in the model maps into the measurement of vertical integration in the data. Following the seminal
work of Adelman (1955), a commonly used index to measure vertical integration is given by the
ratio of value added V A over sales revenues V , i.e., V I =
12
VA
V ;
where value added is de…ned as the
Proposition 3 also implies that vertical integration is preferred for higher (i.e., @V
< 0). This result resonates
@
with the view that independent ownership is better when human capital investments are important, while coordination
of capital investment is better achieved through centralized ownership (see, e.g., Holmstrom and Tirole (1991)).
13
Obviously, this result is only valid in Case 2 of Proposition 3.
14
The linear stealing technology implies that the conditions in Proposition 3 do not depend on the degree of investor
protection ': Decreasing (respectively increasing) returns to scale in the stealing technology favor vertical integration
(respectively non-integration).
13
di¤erence between revenues and material input costs. The idea beyond the index is that, ceteris
paribus, a vertically integrated …rm has higher value added, since more stages of the production
process are performed in-house. The de…nition of vertical integration in the model parallels the
index.
Remark
Under constant value added along the chain across organizational forms (i.e. V Aint = V Ani ),
V Iint > V Ini
4
Extensions
The preceding considerations give some con…dence that the trade-o¤ captured by the baseline
model has practical relevance. This section considers two extensions to the baseline model and
derives testable predictions linking the degree of investor’s protection and vertical integration.
Both extensions combine the baseline model implication that vertical integration is preferred when
pledgeable incomes are higher with well known mechanisms associated with imperfect contracting
and borrowing constraints. The …rst extension introduces contractual imperfections between the
downstream buyer and the input supplier, a force that would normally give an advantage to vertical
integration. The second extension introduces product market competition at the end of the chain
and highlights the role of better investor protection in fostering entry of new …rms in the industry.
4.1
Contractual Imperfections with Suppliers
In practice, the buyer and the seller rarely exchange cash for the input at the same time. Trade
credit is extended by suppliers to buyers whenever inputs are paid for at a later date (see, e.g.,
Burkart and Ellingsen (2004) for an insightful model of trade credit). Conversely, putting-out
systems emerge when buyers collect …nished inputs after having supplied upstream producers with
cash or material advances (see, e.g., Kranton and Swamy (2006) for a model of putting-out systems
inspired by textile manufacturing during the colonial period in India).
Under both systems (trade credit and putting-out), the contractual relationship between the
downstream manager and the upstream manager could be plagued by similar agency problems as
14
the one described in the model between the investor and the entrepreneurs. For instance, in the
case of putting-out systems, the seller could use the cash or material advanced by the buyer to
produce an input that would then be sold on the market. Under trade credit, the buyer could
simply hide cash ‡ows, avoiding repayment to investors as well as to suppliers (and/or employees).
This section discusses a simple extension of the model that allows the buyer to steal revenues
avoiding repayment to the investor as well as to the supplier (or employee). In particular, we
are interested in distinguishing between the degree of “investor protection” ' (i.e., the extent to
which entrepreneurs can steal pro…ts from external investors) and “contract enforcement” , i.e.,
the extent to which buyers can avoid paying suppliers for the input provided.
The model is as in the previous section, the only di¤erence being that entrepreneurs can, at
some cost, avoid repaying input suppliers as well as external investors. After receiving the input
at an agreed price P and producing …nal cash ‡ows V; assume that the owner can hide revenues
and keep (1
')(V
P ) for herself, with
possible to avoid repaying input suppliers. If
the previous section. Conversely, if
1 parametrizing the degree through which it is
! 1; an entrepreneur can only hide pro…ts, as in
! 0; the entrepreneur can steal revenues, and completely
avoid repaying suppliers.
The parameter
is related to the possibility of assuring repayment for the input and does not
depend on the nature of the input transacted (e.g., labour or tools). The parameter
captures
in a simple way the level of di¢ culties in avoiding repayment to suppliers of intermediate inputs,
regardless of whether they are employees of the …rm or arm’s length suppliers on the market. While
can be linked to the technology of production (for instance, if the input can easily be split into
small components that are used at di¤erent dates, then
! 1), our preferred interpretation links
to features of the institutional environment in which the …rms operate.
A …rst interpretation links
to the degree of contractual enforcement. In countries with rela-
tively more e¢ cient courts, it might be harder to avoid payments and circumvent the contractual
obligation of paying suppliers. A second interpretation is that
proxies for the quality of infor-
mal monitoring mechanism available to suppliers. For example, within communities,
should be
expected to be higher. Avoiding repayment to suppliers and hiding pro…ts might be at the same
time more di¢ cult and more costly (in terms of loss of reputation) within a closed community.
The only di¤erence with respect to the baseline model is that the incentive compatibility con-
15
straint to induce debt repayment has to take into account the agency problem between the owner
and her employee/supplier. In particular, given a generic debt level B and an input price p; the
owner repays the investor and her employee/supplier if V
B
where
= (1
(1
'))
'V
p
B
(1
')(V
p); i.e. if
p;
': The key di¤erence with respect to the baseline model is that the
pledgeable income is now reduced by an amount
= (1
')(1
)p; which is increasing in the
input price p:
The model can be solved following the same steps as in Section 3.2. When this is done, the
pledgeable income of an integrated …rm is given by
Pint ( ) = maxf'V
c; (1
)('V
p)g:
(3)
Similarly, the pledgeable incomes of the downstream and upstream …rms are respectively given
p); (1
by Pd = maxf('V
)('V
p)g and Pu = ('p
c): As before, the pledgeable income
of a non-integrated structure is given by the sum of the pledgeable incomes of the two independent
…rms, i.e.,
Pni ( ) = maxf('V
p); (1
)('V
p)g + ('p
Under both structures the pledgeable income is increasing in
c):
(4)
since, through the incentive com-
patibility constraint, the debt level has to take into account the incentive costs associated with
repaying the employee/supplier as well.
Proposition 4
1. If the monetary pro…ts of an upstream …rm,
surplus in the intermediate input market p
income than non-integration, Pint
chain V is high enough, i.e., V
2. If, instead,
(p
c) < p
2 [ ('); (')] with 0
(p
c); are larger than the
c; then vertical integration has higher pledgeable
Pni ; only if the value of the …nal good produced by the
Ve ; and
c; then Pint
e(V; '): Moreover,
@e('; )
@V
0 and
Pni only if V is high enough, i.e., V
(') < (') < 1: Moreover,
@ ('; )
@'
0 and
@ ('; )
@'
@e('; )
@'
0:
V ; and
0.
While the essence of the trade-o¤s described in Section 3.2 is preserved, there are a number of
16
important di¤erences, since the comparison between the pledgeable incomes of the two structures
depends on the degree of investor protection ' and on contractual enforcement :
Imperfections in the enforcement of contracts between the seller and the buyer have an ambiguous e¤ect on vertical integration. On the one hand, since input transactions among independent
…rms occur at higher prices, p > c, the rents necessary to give repayment incentives are higher
under non-integration than under vertical integration. This e¤ect captures the common argument
that vertical integration is preferred in the presence of contractual imperfections. On the other
hand, by increasing the rents necessary to assure debt repayment, contractual imperfections reduce
pledgeable incomes and, as discussed in Section 3.2, favor non-integration.
When pledgeable incomes are low, e.g., because of low '; an increase in contractual enforcement
might raise the pledgeable income to the point at which the joint liability e¤ect kicks-in
and vertical integration becomes the preferred organizational form. At higher levels of pledgeable
incomes, however, a further increase in
erodes the bene…ts of the joint liability, since
@ (p c)
@
< 0:
This e¤ect might lead to non-integration being the preferred organizational form. The relationship
between vertical integration and contractual enforcement
might then be non-monotonic, as in
case 2 in Proposition 4.
How does the institutional environment shape the costs and bene…ts of vertical integration in
terms of pledgeable income? Proposition 4 shows that the degree of investor protection ' and the
degree of contractual imperfections in input markets
on the horizontal axis the quality
interact in a complex way. Figure ?? shows
of contract enforcement between buyers and sellers; and on the
vertical axis the degree ' of investor protection and illustrates case 2 in the Proposition:15
Figure ?? has two main implications. First, …xing '; Figure ?? shows that higher contract
enforcement in input markets leads to lower vertical integration only if …nancial markets are su¢ ciently developed (high '). Otherwise, the increase in pledgeable income implied by higher
makes
vertical integration relatively more pro…table.
Second, since the parts of ' and
that are determined by formal institutions (i.e., legal system,
courts, etc.) are positively correlated across countries (countries with courts enforcing contracts also
protect the interests of external investors), the appropriate comparative statics should be performed
along the diagonal, from bottom-left to top-right. Figure ??, then, casts doubts on the view that
15
The …rst case in the proposition is qualitatively similar to the scenario illustrated in Figure ?? when ' is low
enough.
17
vertical integration should be more prevalent in countries that do not have well-functioning courts
which enforce contracts. Vertical integration dominates non-integration in terms of pledgeable
income only at the intermediate level of institutional development.
4.2
Industry Equilibrium
This section introduces product market competition at the end of the value chain. To simplify
exposition, we mantain the assumption that investors have all the ex-ante bargaining power. This
is consistent with competition in the product market if, for example, there are many potential
investors and each pair of entrepreneurs d and u can only raise funds from one investor (e.g.,
because of monitoring reasons).16
In order to study the industry equilibrium, we …rst need to characterize the optimal …nancing
decision from the point of view of each investor, taking as given cash ‡ows at the end of the chain,
V . The existence of credit constraints implies that both units will not always be …nanced despite
being pro…table.17 In particular, each investor can choose one project ! in the set of available
opportunities, denoted by ! 2
fd; u; ni; intg: She can choose one “large” project, ! = int; in
which case she …nances the entire value chain under the umbrella of a single vertically integrated
…rm. Otherwise, she can …nance two small projects organizing the value chain with two independent
…rms, i.e., ! = ni. Finally, she can choose one of the two small projects, i.e., …nancing only one of
the two units (either u or d), if this option delivers higher expected returns. The subscripts d and
u will denote those two projects.18
The downstream and upstream units …xed costs are kd and ku respectively; while
= ku + kd
are the …xed costs to …nance the entire value chain, regardless of organizational form, i.e., kint =
kni = . The (net) present value P V! of a project ! 2
is given by the di¤erence between the
expected returns from the project and the corresponding …xed costs. The expected returns are
simply given by the pledgeable incomes derived in the previous section. Therefore, P V! = P!
16
k! :
For the sake of expositional simplicity, the analysis focuses on the baseline model in Section 2 and sets = 1.
There are credit constraints in the sense that there exist pro…table investment opportunities that cannot be
…nanced because of low investor protection. This follows from maxfPint ; Pni g < V C; where C = c + (1
)p is
the level of expected costs.
18
Since, as noted in Section 3.1, the pledgeable income of two non-integrated …rms Pni is given by the sum of the
pledgeable incomes of the two units, i.e., Pni = Pu + Pd ; the option ni available to the investor is simply the sum of
the two projects d and u:
17
18
The investor chooses the option ! 2
that delivers the highest returns.
Since the pledgeable income under non-integration is equal to the sum of the pledgeable incomes
of the two independent …rms, Pni = Pu + Pd ; the condition Pni > Pint implies that, if both units
u and d deliver positive returns, i.e., Pd > kd and Pu > ku ; the investor …nances a non-integrated
value chain and vertical integration never arises. If either of the two projects has a negative
return, the investor does not …nance it. If, however, Pint > Pni ; vertical integration emerges in
equilibrium only if it delivers higher returns than any combination of the two smaller projects d
and u: Pint > Pni is necessary but not su¢ cient for vertical integration to emerge. The necessary
and su¢ cient condition for vertical integration to be chosen by the investor is that
Pint
maxfPu
ku ; 0g + maxfPd
kd ; 0g
Pni
(5)
For su¢ ciently high levels of investor protection '; vertical integration is always chosen if Pint > Pni ,
while for extremely low values of '; no …rm can be …nanced at all. At intermediate levels of investor
protection, however, two alternative scenarios might arise, depending on whether a small …rm can
be …nanced or not.19 The following Lemma summarizes the preciding discussion and characterizes
the investment decision as a function of investor protection '.
Lemma 1 a) If Pint < Pni ; vertical integration is never chosen. Moreover; there exist unique
'0
'
'00 ; such that no …rm is …nanced if '
'00 and non-integration is chosen if and only if
'0 :
b) If Pint
Pni ; there exist thresholds ' and ' ; with ' ? ' ; such that vertical integration
is chosen if and only if '
' and no …rm is …nanced if '
minf' ; ' g:
It is worth noting two implications of the Lemma. First, while the size of the two units, or
plants, d and u is …xed, and given by kd and ku ; the size of a …rm is endogenous to the model: a
19
Let '! be implicitely de…ned by P! = k! : If 'int > minf'd ; 'u g; a small …rm can be …nanced for intermediate
levels of ': When one of the two independent …rms cannot be …nanced, it is possible that …nancing a small …rm
delivers higher returns to the investor than …nancing the entire chain. For example, if Pu ku < 0; it might be
the case that …nancing the downstream …rm alone delivers higher returns to the investor than …nancing a vertically
integrated …rm, i.e., Pd kd > Pint
: If, instead, 'int < minf'd ; 'u g; at intermediate levels of investor protection
both independent …rms are unpro…table, while a vertical integrated structure still yields positive returns. Under those
circumstances; only a vertically integrated …rm or no …rm at all is …nanced.
19
vertically integrated …rm has size kd + ku while non-integrated …rms have size either equal to kd or
ku : The …nancial constraints implied by low investor protection, therefore, can take di¤erent forms
depending on the type of industry. In industries in which Pni > Pint , …nancial constraints a¤ect
the creation of …rms. In industries in which Pint > Pni ; instead, …nancial constraints a¤ect the size
of …rms. Second, if investors/entrepreneurs are heterogenous with respect to ' or initial wealth;
within industries those with a higher ' are more likely to …nance/run a vertically integrated …rm.20
Product Market Competition and Industry Equilibrium
Having determined the optimal investment from the point of view of each investor taking as
given cash ‡ows generated at the product market, we endogenize the number (mass) of value chains
…nanced in the industry. Let us assume that the industry faces an aggregate demand schedule P (Q)
for the …nal good; where P is the price at which Q units of the good can be sold on the market,
and P 0 (Q) < 0: Let P (Q) < P for all Q:
Since each …rm produces only 1 unit of the …nal good, the supply in the industry is given by
the number (mass) N of …rms that are …nanced in equilibrium, i.e., Q = N and V = P (Q): Free
entry requires that, in equilibrium, it is not possible to …nance any additional …rm without implying
losses for the investor. This, in turn, implies that the pledgeable income of the marginal entrant
must be exactly equal to the investments required to start a …rm.21
Therefore, in an equilibrium in which the entire value chain is …nanced under organizational
form i 2 fni; intg; it must be that
ku + kd = Pi ('; V (N )):
(6)
Conditional on both units being …nanced, the free-entry condition (6) captures the common
intuition that better investor protection leads to higher entry and lower equilibrium pro…ts. Higher
investor protection ' always increases N; the mass of …rms entering the industry. In equilibrium, free entry implies that all investors earn zero pro…ts. Since, under both organizational form
20
When 'int < minf'd ; 'u g either large, vertically integrated …rms are …nanced or no …rm at all, since no investor
can …nance a …rm with medium size ku or kd . The model then suggests a ‘missing middle’ in the distribution of
…rm sizes, a typical feature of the industrial organization of developing countries (see, e.g., Tybout (2000), Cull et al.
(2005), Little et al. (1988), Snodgrass and Biggs (1996), Cabral and Mata (2003)).
21
Since all entrepreneurs / projects are identical, in equilibrium the marginal …rm entering the market has the
same organizational form of all other …rms in the industry.
20
i 2 fint; nig; the pledgeable income (and therefore investor’s returns) are increasing in investor
protection '; the pro…ts of each value chain must decrease when investor protection improves. This
happens through an increase in entry, N; which, increasing competition in the …nal product market,
lowers revenues V (since V = P (N ) and P 0 (N ) < 0).
So far, we have focussed on the case in which the entire value chain is …nanced. The following
proposition combines the insights of Proposition 3 (Pni > Pint if V is low), Lemma 1 and the free
entry condition (6) to fully characterizes the industry equilibrium.
Proposition 5 In the industry equilibrium with free-entry, the degree of investor protection ' has
a non-monotonic e¤ ect on vertical integration. In particular, there exist thresholds ' ; '+ and '0
such that vertical integration emerges in equilibrium for intermediate values of '; i.e., ' 2 [' ; '+ ]:
Two non-integrated …rms are …nanced in equilibrium if ' > '+ ; while a single non-integrated …rm
is …nanced at low '; i.e., if ' 2 ['0 ; ' ]: Finally, no …rm is …nanced if ' < '0 :22
Combining the negative relationship between V and ' implied by the free entry condition
(6) with the results in Proposition 3 and Lemma 1, the model captures the dual role of investor
protection on vertical integration. When ' is su¢ ciently low it might not be pro…table to …nance
an upstream …rm (ku < ' (p
c)), and the choice is between …nancing a small downstream …rm or
a large vertically integrated …rm. The former solution emerges when ' is very low, while vertical
integration emerges when ' is higher. When investor protection further increases, more …rms enter
the industry, and pro…ts are lower. Eventually, non-integration becomes the organizational form
that assures the highest returns to investors. Proposition 5, therefore, implies a non-monotonic
e¤ect of investor protection ' on vertical integration: low investor protection mostly hinders …rm
expansion, i.e., higher ' would allow small non-integrated downstream unit to vertically integrate.
When ' is su¢ ciently high, however, better …nancial markets allow more …rms to enter the industry
implying that the value chain eventually disintegrates into two non-integrated …rms.23
22
One of the two intervals I
[' ; '+ ] and I
['0 ; ' ] might be empty. They cannot both be empty.
A further prediction is that higher capital intensity, i.e., greater = ku + kd ; favours vertical integration. For
a given level of ', higher equilibrium revenues V = P (N ) are required to sustain higher capital investment . As
seen above, when revenues are higher vertical integration delivers higher pledgeable income than non-integration, and
therefore becomes the equilibrium organizational form.
23
21
5
Evidence
This section discusses evidence on the relationship between vertical integration and …nancial markets development. Section 4 combined the key insight from Proposition 3 with well known mechanisms associated with imperfect contracting and borrowing constraints. Before discussing the
evidence, it is worth summarizing the main testable predictions of the model:
Summary of Testable Predictions:
i ) better contract enforcement with input suppliers (resp., investor protection) reduces vertical
integration if investor protection (resp., contract enforcement) is su¢ ciently high;
ii ) better investor protection has an inverted-U relationship with vertical integration.24
The part of the …rst prediction on the relationship between vertical integration and better
contract enforcement with input suppliers is consistent with anecdotal evidence on subcontracting
within networks of small …rms in community-based industrial districts (see, e.g., Humphry (1995)).
Brusco (1982), for the case of Italy, describes the organization of production in the industrial
districts in Emilia-Romagna, a region well known for its high levels of social capital (high
).
The organization of production is characterized by extensive subcontracting and very low levels
of vertical integration. In contrast, Banerjee (2004) and Banerjee and Munshi (2004) discuss
examples of community-based industries in India with relatively high degrees of vertical integration.
For instance, the Stitched Garment industry in Calcutta is organized in relatively small but fully
vertically integrated …rms that almost exclusively employ workers of the same community as that of
the owner of the …rm (often migrating from remote rural areas). Similarly, in the Knitted Garment
industry in Tirupur, the …rms belonging to the local dominant community, and which presumably
have access to higher
than …rms owned by outsiders, are more vertically integrated than …rms
owned by outsiders, which tend to be relatively disintegrated. If …rms in Italy have better access
to capital (higher ') than …rms in India, these facts are consistent with our model. In the case
of Italy, then, the model shows that tight community ties allow for a decentralized organization
of production. In the case of India, however, the tight community ties lead to production being
carried within vertically integrated …rms.
24
This second prediction is implied by both extensions, although through a di¤erent economic mechanisms.
22
More generally, the …rst prediction is consistent with empirical evidence on di¤erences in the
degree of vertical integration across countries. For instance, Rajan and Zingales (1995) note that
corporate balance sheets in countries with developed …nancial systems have relatively larger items
re‡ecting interactions among …rms (i.e., less vertical integration, top-right corner in Figure ??).
Similarly, Acemoglu et al. (2006) do not …nd that di¤erences in formal contract enforcement
institutions across countries linearly correlate with the degree of vertical integration. However, they
do …nd that …nancial development and contracting costs interact: vertical integration is signi…cantly
greater in countries with higher contracting costs and greater …nancial development (bottom-left
to top-left in Figure ??).
I am not aware of evidence directly supporting the second prediction of the model. However,
there is ample support for the two mechanisms that form the basis for the prediction: i) poor investor
protection (low ') leads to more concentrated industries in which …rms enjoy higher rents (higher
V ), and ii) higher rents imply higher vertical integration. First, there is ample evidence suggesting
that poor …nancial development limits the entry of …rms and is associated with concentration. For
instance, in the context of the nineteenth-century textile industry, Haber (1991) convincingly shows
how poor access to credit has been a major determinant of the degree of concentration. He provides
a comparative analysis of the cotton textile industry in the United States, Brazil and Mexico. He
…nds that Mexico and Brazil, with far less developed and more segmented capital markets, exhibited
very high levels of concentration in the industry, with large …rms dominating the industry. At the
turn of the century, Brazil passed reforms which improved the working of the …nancial system. This
led to a rapid growth of the textile industry in Brazil, and a reduction in the level of concentration.25
The relationship between …nancial development and industry concentration is not speci…c to the
nineteenth-century textile industry. In a recent paper, Mitton (2008) uses a new dataset of 1.3
million …rms from over 100 countries and shows that concentration is higher in countries with lower
investor protection and other regulatory barriers that restrict entry and competition.26
Having established that low …nancial development leads to higher concentration and increases
25
The cotton textile industry is an ideal setting to analyze the e¤ects of …nancial development on market concentration since, according to Haber (1991), in the early textile cotton industry “the usual mechanisms by which …rms
obtain market control were lacking” and “no signi…cant barriers to entry existed” in the industry (other than credit
constraints).
26
Similarly, Beck et al. (2005) …nd, in a di¤erent …rm-level survey database covering 54 countries, that …nancial
underdevelopment constrains the growth of smaller …rms.
23
rents by sheltering …rms from competition, we need to show that …rms in less competitive environments are more vertically integrated. There is evidence supporting this prediction too, although
the evidence relies on rents generated by trade protection rather than low …nancial development.
Trade policies have been an important determinant of the degree of competition to which …rms in
the nineteenth-century textile industry were exposed. For instance, Temin (1988) notes that powerful interest groups in New England ensured very e¤ective trade protection to the textile industry.
Similarly, Brown (1992) reports that the German textile industry also enjoyed a very high level of
protection in the late nineteenth century. In both Germany and New England …rms were substantially larger and more vertically integrated than in England, where …rms were instead exposed to
a more competitive trade regime.
Similar evidence can be found in the automobile industry in the United States at the beginning
of the twentieth century. Helper and Hochfelder (1996) report that credit was a substantial problem
in the organization and expansion in the early years of the industry (when V was, presumably, still
low). While the degree of vertical integration varied from …rm to …rm, virtually all automobile
companies began as assemblers rather than as manufacturers, implying low degrees of vertical
integration. While the industry witnessed a trend towards vertical integration in the 1920s, during
the boom of the car market (higher V ), Langlois and Robertson (1989) show that the Depression
reverted the trend, with the share of intermediate inputs purchased from external suppliers going
up. In the absence of signi…cant technological innovations, the reduction in market size (lower V )
and the more di¢ cult access to credit (lower ') were the major determinants of the organizational
shift away from vertical integration.27
6
Discussion
E¢ ciency
In order to focus on the e¤ects of vertical integration on the capacity to raise external …nance, we
27
Porter and Livesay (1971) and Banerjee and Munshi (2004) provide evidence that, within industries, entrepreneurs
with better access to external …nance run more vertically integrated …rms. Porter and Livesay (1971) show that, in
the early phase of industrialization of the cotton textile industry in New England, wealthy merchants owned …rms that
were backward vertically integrated into production stages. Rich entrepreneurs who were connected to local banking
elites owned vertically integrated …rms with larger plants, while “outsiders” operated smaller vertically disintegrated
…rms. Banerjee and Munshi (2004) in the garment industry in Tirupur describe an environment which is similar to
Porter and Livesay (1971). This evidence is consistent with the remarks after Lemma 1
24
have made two key assumptions: i) production e¢ ciency is the same under the two organizational
forms, and ii) the investor has all the bargaining power. We now discuss those two assumptions in
greater detail.
The assumption that production e¢ ciency is the same under both organizational forms implies
that the only e¢ ciency implications that can be derived from the model concern whether …rms get
started or not.28 The model does not deliver predictions about whether there is “too much”or “too
little” vertical integration. It is possible to consider a case in which one of the two organizational
forms is more e¢ cient than the other without a¤ecting the trade-o¤ described in the model. In
general, if the organizational choice is chosen to maximize pledgeable income, there is no guarantee
that it will be the e¢ cient one.
Competitive Credit Markets
The second assumption is that the investor has all the bargaining power, and the organizational
form is chosen to maximize her returns. What happens, instead, if the credit market is competitive?
Keeping the assumption that it is pro…table to …nance the entire value chain, we start by noting
that, at the ex-ante contracting stage, the two managers bargain over the organizational form to be
chosen. The outside options of the downstream and upstream managers in the ex-ante bargaining
depend on whether their …rms can be …nanced or not.
The main insights of the model are robust to the case in which the credit market is competitive.
This is because two cash constrained managers tend to chose the organizational form that maximizes
the amount of money they are able to raise from external investors and transfer the borrowed money
according to the ex-ante distribution of bargaining power, enabling them to reduce ine¢ ciencies
in bargaining. As in the baseline model, Pint > Pni is a necessary but not su¢ cient condition
for vertical integration to arise.29 Similarly, vertical integration is never …nanced if it has a lower
pledgeable income than non-integration, i.e., Pint < Pni : Note, however, that the condition Pni >
28
For instance, if 'int < minf'd ; 'u g, for intermediate levels of investor protection '; vertical integration facilitates
the …nancing of two projects that could not be …nanced as two separate …rms.
29
To see why, assume that vertical integration is feasible, i.e., Pint > kd + ku . If both Pd > kd and Pu > ku the
total surplus available to the two entrepreneurs is the same under the two organizational forms and therefore vertical
integration cannot strictly increase the pay-o¤ of a manager without violating the participation constraint of the
other manager. In this case, however, the borrowing constraint is not binding. If, instead, Pd > kd and Pu < ku ; then
vertical integration emerge, since the outside option of the u manager is equal to zero and can be easily compensated.
Finally, if Pd < kd and Pu > ku ; vertical integration only emerges if it allows to borrow enough to compensate the
upstream manager for giving up her …rm, i.e., if Pint
(p c) > kd :
25
kd + ku is necessary but not su¢ cient for the entire value chain to be …nanced. If one of the …rms
cannot be …nanced independently, i.e., either Pd < kd or Pu < ku , the owner of the …rm that can
be …nanced will not agree to a contract that …nances the other …rm as well, and ine¢ ciencies arise.
Wealth can also be added to the model. A wealthier entrepreneur is more likely to be able to
…nance her own …rm, and will therefore have a better outside option. Whether this leads to more
or less vertical integration, however, depends on which manager has the wealth.30
Contractual Externalities
By focussing on the case in which
When
' 1; the model has removed ex-ante contractual externalities:
< 1; the two projects become linked by a common destiny and potential externalities arise.
To see why this is the case, note that, when the upstream project has not been …nanced, the net
present value of the downstream project is given by
P Vd0 = V
p
(1
)p
kd :
Similarly, when the downstream …rm is not …nanced, the net present value of the upstream …rm is
given by
P Vu0 =
( p
c)
ku :
The net present value of the entire chain is given by
P Vc = V
In other words, when
c
(1
)p
k > P Vd0 + P Vu0 :
< 1, the whole chain is worth more than the sum of its parts. Decentralized
investors typically will not replicate the contracts signed by a sole investor, as the investor …nancing
the upstream unit might not take into account the positive e¤ect on the net present value of the
downstream unit, and vice versa. It can be shown that these externalities might lead to underinvestment or to more vertical integration in the presence of inequality in borrowing capacity among
entrepreneurs.
30
Property rights theories of the …rm with …nancially constrained entrepreneurs (see, e.g., Legros and Newman
(2004)) also predict that the allocation of control rights is twisted in favour of the party with more bargaining power
or wealth. The ex-ante distribution of wealth and bargaining power, however, is likely to be context speci…c in
practice and di¢ cult to observe in the data making those theories hard to test empirically.
26
Further Remarks
The model abstracts from other factors that are likely to a¤ect the integration decision of small
and medium-sized …rms in developing countries. An often quoted constraint on …rms in developing
countries is uncertainty in input supply (see e.g. Mookerjee (1999)). Since less developed countries
are likely to be characterized by more uncertain and volatile input markets, vertical integration
could be relatively more prevalent in those countries. If better …nancial markets increase entry
(and reduce uncertainty) in input markets, a further negative e¤ect of …nancial development on
vertical integration should be observed in the data.31
Since the main bene…ts of vertical integration come from joint liability, a previous version of
the paper studied joint liability contracts among independent …rms.32 Restricting attention to
collusion-proof contracts, in which the investor cannot hold claims on the pro…ts of the …rm which
depend on the identity of the contractual parties involved in the input transaction, the model shows
that joint liability does not change the condition under which vertical integration delivers higher
pledgeable income. In other words, the bene…ts of joint liability are better achieved under vertical
integration: joint liability and centralized allocation of control rights are complementary tools in
the hands of the external investor to maximize pledgeable income.33
7
Conclusions
This paper explores the connections between investor protection and vertical integration. It has
derived the costs and bene…ts of vertical integration from the point of view of an external investor:
vertical integration trades o¤ the bene…ts of joint liability against the costs of rendering the supply chain more opaque to external investors. In contrast to standard arguments that link higher
degrees of vertical integration to more pervasive input and capital market imperfections, the tradeo¤ implies that the relationship between vertical integration and the quality of the institutional
environment is a complex one, and that more vertical integration should not be expected in devel31
Macchiavello (2006) …nds evidence consistent with this e¤ect in a cross-country-industry setting.
Joint liability contracts between independent …rms can take the form of loan or mutual debt guarantees (as
opposed to collateral) and have been documented in several contexts (see, e.g., Cull et al. (2005) for historical
examples, or Park and Shen (2003) for contemporary China).
33
This result is in line with the work of business historians and legal scholars who de…ne the …rm as a nexus
of contracts characterized by centralized allocation of control rights and joint liability (see, e.g., Cheung (1983),
Hausmann and Kraakman (2001), and Lamoreaux (1998)).
32
27
oping countries. In particular, the model predicts that vertical integration is more likely to arise
for intermediate levels of investor protection and that better contract enforcement reduces vertical
integration only if …nancial markets are su¢ ciently developed. We have discussed various sources
of evidence which is in line with both predictions.
This paper has taken the view that the institutional environment, as opposed to technological
considerations, is a major determinant of organizational forms. Future theoretical work should
explore the interaction between …nancial and other institutional constraints on industrial structure,
supply chain performance, technology adoption, and organizational forms. Eventually, this line of
research will not only improve our understanding of …rms and markets but will also lead to better
design of policies aimed at fostering industrial upgrading and development.
.
28
8
Appendix
Proof of Proposition 3:
Note …rst that Pni and Pint are strictly increasing, convex and piecewise linear in V; and that
their slopes with respect to V are either equal to ' or to '(1
): This implies that the two
curves will cross once at most. When V is su¢ ciently large, we have Pint > Pni if and only if
(p
c)
(p
c) (denote this as condition N ). When, however, V is su¢ ciently low, we have
Pint < Pni : The two curves cross exactly once if (p
(p c)
(p
c) ; then (V
c) > (V
Ve = p +
)c (1
)p
(p
c) and never cross otherwise. If
p)+ p and since (1
the two curves must cross when Pint = '(V
(1
c)
)(V
p)+ (p c) > (1
c) and Pni = '((1
)(V
)(V
p) + (p
p);
c)): Let
be the unique solution to this equation. To conclude the proof of the
Proposition, note that straightforward di¤erentiation implies
@ Ve
@
< 0;
@ Ve
@
< 0:
Proof of Remark:
Consider …rst the case p = p: To see that the value added is constant under the two organizational forms note that under integration V Aint (p) = V
c while under non-integration
V Ani (p) = V Ad (p) + V Au (p) and since V Ad (p) = (V
V Ani (p) = V
p) and V Au (p) = (p
(1 Vp )+
c: The indexes are therefore V Iint (p) = 1 Vc > V Ini =
2
Consider now the case p = p: We have V Aint (p) = V Ani (p) = V
c) we have
1
c
p
.
p: As V Au (p) = 0: It follows
that V Iint (p) = V Ini (p): Finally, the fact that any convex combination of the two cases implies
V Aint = V Ani and V Iint > V Ini concludes the proof.
Proof of Proposition 4:
The proof of the Proposition mimics the proof of Proposition 3. Note …rst that Pni and Pint
are strictly increasing, convex and piecewise linear in V; and that their slopes with respect to V are
either equal to ' or to '(1
): This implies that the two curves will cross once at most. When
V is su¢ ciently large, we have Pint > Pni if and only if (p
c) > ( ' p
c): When, however, V
is su¢ ciently low, we have Pint < Pni : The two curves cross exactly once if (p
and never cross otherwise. If the two curves cross, they do so when Pint = 'V
(1
)('V
p) + ('p
c): Rearranging terms gives that Pint
( ; ') = minf (V; '; ); ('; )g
29
c(1
c) > ( ' p
c and Pni =
Pni if and only if
)
c)
where we have
(V; '; ) =
straightforward to show that
1
'
(1 ')
@
@z
> 0 and
('; ) cross at some ; then
Note that
('; 1) = (1
(V
p) + (1
@
@z
)p and
('; ) =
)p; and therefore, if
is increasing in V and (V; '; 1) =
0 and
@e('; )
@'
(p
c) > p
c; then
(V
p) + (1
('; )
c(1
)
(V; '; ) > c(1
):
)p does not depend on '; there is a
is high enough. Applying the implicit function theorem gives
c; then
('; ) < c(1
) for
high enough. This implies that
Pint > Pni only for values of V e de…ned by (V e ; '; ) = ('; ) such that (V e ; '; )
Solving the two equations in succession, we obtain that the minimum V is given by V =
Moreover, since
p: It is
0:
c) < p
If, instead, (p
'
(1 ')
( ; ') is non-monotonic.
unique V above which Pint > Pni if
@e('; )
@V
1
< 0 for z = '; : This implies that if (V; '; ) and
for all ' and : When this is the case, we have Pint > Pni if and only if
Since
1
('; 1) < c(1
the same time, we need
); the condition can only be satis…ed for
(V; '; ) > c(1
); i.e. 0
c(1
p (1
p p (1
):
)p
)c :
< (') < 1: At
(') < : Again, applying the implicit
function theorem gives the comparative statics result and concludes the proof of the proposition.
Proof of Lemma 1:
Consider …rst the case Pint
Pni : Since Pint and Pni are both strictly increasing functions of
'; there exists a unique ' such that Pint (' )
Obviously Pni (' )
k
k = 0 and integration is not chosen if ' < ' :
0; and therefore the two …rms are never …nanced in a non-integrated way.
De…ne 'd and 'u as the thresholds of ' at which Pd ('d )
Since Pni = Pd + Pu
Pint it follows that maxf'd ; 'u g
if Pni = Pint and 'd = 'u : De…ning '
kd = 0 and Pu ('u )
ku = 0 respectively.
' ; with equality holding if and only
= minf'd ; 'u g; and noting that '
7 ' depending on
parameters, concludes the proof of the …rst part of the proposition.
The proof of the second part of the proposition is very similar. Obviously, there exists a unique
'0 = maxf'd ; 'u g such that if '
'0 two …rms are …nanced, and non-integration is chosen.
Similarly, de…ning '00 = minf'd ; 'u ; ' g; if '
'00 no …rm is …nanced. For ' 2 ('0 ; '00 ) one …rm is
…nanced (either the downstream …rm, the upstream …rm or a vertically integrated …rm). However,
since Pni = Pd + Pu > Pint simple algebra shows that minf'd ; 'u ; ' g =
6 ' ; and therefore vertical
integration never arises in equilibrium. This concludes the proof.
30
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